David R. Henderson  

Externality

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In my Executive MBA economics class a little over a week ago, I presented the following definition of a negative externality:

A cost borne by someone who is not party to the decision that caused the cost.

Then I asked the students for examples of negative externalities. One tried and true example in the textbook, The Economic Way of Thinking, by Heyne, Boettke, and Prychitko, is air pollution. I was ready to go with that if the students didn't come up with anything. They typically do, though, and so I didn't have to wait long.

One student raised her hand and I called on her. She gave the example of a school board of a government school district that had voted for large pensions for teachers, pensions that would be paid for by taxpayers rather than by the board members themselves.

I could have hugged her.

So often we economics professors stick to the kinds of externality examples we were taught when we learned economics. And that was my mindset that morning. But there's a sea of examples of externalities, typically negative, created by government officials. She put her finger on one.

I wrote about Harold Demsetz's example earlier here.

Update: Glen Whitman has written about this here.


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COMMENTS (20 to date)
Don Boudreaux writes:

David,

You've got an astute student there!

Coincidentally, the point she made is very similar to a central point in Jim Buchanan's article ("Politics, Policy, and the Pigovian Margins") from which I draw today's "Quotation of the Day" for my blog.

Justin writes:

Isn't that a principal-agent problem rather than a negative externality? The school board has been charged by the population to define a compensation package that allows it to attract and retain good teachers. The fact that the school board does this unwisely (either as a point of fact or in the opinion of some members of the community) is unfortunate. But I don't see how it qualifies as a negative externality. The taxpayers are still a party to the decision, they've simply delegated decision-making to their agents.

If every decision an agent makes that a principal disagrees with is a negative externality, that would seem to create some weird results. If my neighbor and I have a disagreement and we each hire a lawyer to negotiate a settlement, do we each suffer negative externalities to the extent that the negotiated settlement departs from our ideal outcome merely because we weren't at the negotiating table? If so, then the concept of a Cosean bargain would fall apart if it was negotiated by agents since whatever we gain in the bargain would by definition by lost as a negative externality of the bargain.

My neighbor mows the lawn at 7am every Sunday. He values getting an early start on chores at $5. I value getting an extra couple hours of sleep at $10. If I pay him $7 to wait until 9am to mow the lawn, we're both better off. If our lawyers get together and negotiate the same agreement, under this definition, I suffer a $7 negative externality since I wasn't a party to the decision which wipes out the gains of the trade.

Justin writes:

If we're looking for negative externalities created by government policy in the story, there are a couple.

If the pension promises are large enough and the pension funding is small enough to cause the district's pension plan to go bankrupt, some other set of taxpayers who were truly not party to electing the school board will likely be on the hook for a bailout. That's clearly a negative externality. Similarly, I'd happily argue that the government's decision to allow municipalities to run pension plans on cash basis accounting which causes pensions to look unrealistically inexpensive and causes municipalities to make inefficient choices between current and future compensation is a serious negative externality.

foosion writes:

The individuals comprising the taxpayers of XYZ may change, but the costs continue to be borne by the taxpayers of XYZ. That's not really a cost borne by a third party.

Edge cases are often contentious and arguing definitions is seldom satisfying, but this does not seem like a classic externality. It seems more an attempt at guilt by association - try to label something you don't like with a negative label.

Philo writes:

A house comes on the market. I make an offer. The owner is about to accept my offer when someone else makes him a better offer, which he accepts. Thereby I suffer a negative externality.

RohanV writes:

What about a situation where a CEO decides to lay off 5000 workers? The workers were not party to the decision, but they bear the cost. Does that make the layoffs a negative externality?

Or does "party to the decision" include examples where the people are part of the same hierarchy or structure? If so, then surely the community and it's lawfully elected officials bear the same relationship.

Jon Murphy writes:

Funny, I had a similar thought today too (although mine was along the lines of minimum wage leading to layoffs or less hiring)

Gene Laber writes:

Isn't there a distinction between the externality that you were thinking of--air pollution--and the pecuniary externality offered by the student? Your example affects the allocation of resources. A pecuniary externality redistributes, but does not distort resource allocation.

Jon Murphy writes:
What about a situation where a CEO decides to lay off 5000 workers? The workers were not party to the decision, but they bear the cost. Does that make the layoffs a negative externality?

I would say so, but perhaps not for the reason you cite. The CEO's decision was made for (presumably) a cost-cutting reason (I say "presumably" because I doubt there are any CEOs out there who just fire people for fun). This would mean his/her hand was forced likely because of falling demand for their product. So, the negative externality would be stemming from a change in consumer preference, rather than the CEO's decision. The CEO's decision is largely incidental, rather than causative.

Phil writes:

David - Since many (most?) of those students are uniformed or civilian members of the military, I am curious how many identified military examples of negative externalities, and what they were.

David R. Henderson writes:

@RohanV,
What about a situation where a CEO decides to lay off 5000 workers? The workers were not party to the decision, but they bear the cost. Does that make the layoffs a negative externality?
No. In fact, the workers are party to the decision. They got laid off. They’re in a market relationship with the CEO and are capable of renegotiating. If they can’t because he refuses, that means that he anticipates that they can’t reach a mutually agreeable decision.
Similarly, if the worker quits and the CEO and his company suffer a loss (think of some particularly experienced employee who knows the software better than anyone else), the CEO and the company do not suffer a negative externality.

David R. Henderson writes:

@Gene Laber,
Isn't there a distinction between the externality that you were thinking of--air pollution--and the pecuniary externality offered by the student? Your example affects the allocation of resources. A pecuniary externality redistributes, but does not distort resource allocation.
The student’s example is not of a pecuniary externality. This one does distort resource allocation. Think about why.

David R. Henderson writes:

@Phil,
David - Since many (most?) of those students are uniformed or civilian members of the military, I am curious how many identified military examples of negative externalities, and what they were.
Most.
Zero.
In the previous class, in which I discussed the rudiments of public choice, I think I gave Bush Jr. and Obama as examples of people making decisions for which they bore little of the cost. With Bush, I used his invasion of Iraq and with Obama, I used his attack on Libya. But I didn’t use the term externality because that term did not appear in the chapter we were discussing.

Tony M. writes:

I'm a physician with no formal econ training. The first thing that came to my mind is "doctor and patient decide on an expensive treatment that is 100% covered by insurance". Neither party bears the cost.

I see this dynamic play out daily in my work, especially near the end of the fiscal year , when out-of-pocket limits an/or deductibles have been reached . Patients become much more eager to undergo elective procedures, compared to the beginning of year when they shoulder a larger burden of the cost.


ThomasH writes:

That's a non-standard way of defining "externality." The standard way is that it is a cost directly imposed, not through a market transaction. If I get sick from living downwind from a coal-fired electricity generation plant, that's an externality. If my customers of my candle business stop patronizing me because they now can buy electricity from the plant, that's my tough luck, but not an "externality." The student was right by your definition, but not by the standard one.

Besides, the the example the student gave is more like a breach of fiduciary responsibility (I'm assuming that the student supposed that the pension was not the most cost-effective way of compensating teachers), than an "externality.

Bill writes:

Mark Pennington has a nice, short video on this topic:

https://www.youtube.com/watch?v=vzLyybYmYjU

Jim Glass writes:
"A cost borne by someone who is not party to the decision that caused the cost."
I'll natter as a nabob of negativity here, to disagree with this definition and defend "the kinds of externality examples we were taught when we learned economics", for purposes of discussing economics (as opposed to casual colloquial chatter).

The standard economic definition and examples of externalities relate to the effects of costs not being reflected in market prices. E.g., as per the unimaginatively orthodox IMF:

What happens when prices do not fully capture costs ... market outcomes can lead to underproduction or overproduction in terms of a society’s overall condition

That's an important concept! But if one removes market prices from the discussion and just defines an "externality" as some cost (or benefit) that one party dumps on another, well, that could result from rent seeking, agency problems, any kind of political failure, or even private action like throwing momma from the train to impose the cost of being an orphan on baby.

The important original concept of 'market prices leading to market under- or over-production' is entirely lost.

"But there's a sea of examples of externalities, typically negative, created by government officials. She put her finger on one."
I don't know about that. She put her finger on a cost to be "paid for by taxpayers". And, yes, by your definition taxes would likely be a whale in that sea - not just as to the direct cost of taxes on taxpayers but also as to the additional deadweight cost of taxes imposed on society that rises by the *square* the the increase in tax rates. Surely a Moby Dick externality in your terms.

Yet I've worked with tax analysis my entire professional life and don't remember the cost of taxation being referred to as an "externality" even once, as taxes aren't a market price. Moreover, when one draws supply-demand graphs for a negative externality and the cost of taxation, one gets two entirely different things -- indeed opposite! [1] [2] Negative externalities result in production that is too high, the cost of taxation results in production that is too low.

People changing the use of a word so its clear original meaning is lost and it comes to mean two very different, even opposite things, at the same time ... forcing people like me to come up with two new words to cover the original meanings ... hey, that feels like a negative externality being dropped on me!


David Henderson Author Profile Page writes:

Jiim Glass,
Thanks for your thoughtful comment.
I want to point out one implication of your narrow concept of externalities, one that MUST involve market prices that don’t reflect a particular cost. Imagine that someone is producing food for his own use and sells none of it. So there are no market prices. In the production process, he lets fertilizer run into a river and pollute people downstream. In my understanding, he is creating a negative externality. In yours, he is not. Are you comfortable with that implication?

Sergio Martinez writes:

I wish I was as bright as her when I was a student.

mickey89 writes:

"The school board has been charged by the population to define..."

Bit of a stretch there.

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